Political Winds
Christopher P. Lorenz
The recent elections significantly shifted political winds as voters expressed frustration with the war in Iran and persistent inflation exacerbated by tariffs, and social issues. The immediate response to the election was a pop in the stock market, which was a knee jerk reaction to a smooth transfer of power and relief that divided government means that policy changes will allow both parties to participate. Today, as that euphoria wears off, there is fear that the shift in political winds may bring turbulence negatively impacting our economy. Earlier this year I described the growth drivers in our economy as a mega-trend related to AI spending. Numerous states had referendums placing moratoriums or restrictions on building data centers. If these projects are disrupted, it will likely slow down the economy and corporate earnings, but this narrative isn’t new.
The election results were largely anticipated and public concerns related to AI and data centers have been front and center for some time. Stocks related to the buildout of data centers, and the industries that serve them, have been under pressure since the summer, potentially signaling less investment in these sectors. So, with political winds shifting, should we change course and take a new track? The answer lies in how we view the current economy and what’s on the horizon for 2027.
The economy is healthy. The third quarter report on Gross Domestic Product (GDP) showed 3.4% growth year over year, which is well above trend growth. A significant portion of the growth came from the economic activity around the AI buildout, which reaches far beyond semiconductors and computer systems. The capital spent enhancing the electrical grid and local development has created jobs and economic activity. We have also seen some economic headwinds like energy costs and higher interest rates. The issue we see in the macro-economy is that the majority of growth exists in a narrow sector of the economy and important sectors like housing, although a weak housing sector improves affordability. Home prices have been falling nationally and inventory is rising, both of which is good for Americans. Lower interest rates are also beneficial to the housing industry.
So, the economic outlook is positive, even with a modest slowdown in AI spending. More importantly, we have healthy corporate earnings. S & P 500 earnings grew more than 20% this year. Looking toward the horizon, 2027 S & P earnings are projected to be around 14%, which, though above long-term averages, still represents a slowdown, impacting stock prices.
The dramatic selloff in AI infrastructure and technology stocks over the past few months makes sense as earnings growth decelerates. Large cap tech stocks, like the “magnificent seven”(GOOG, MSFT, etc.) shifted from producing significantly positive cash flow to negative due to their data processing spending. It also makes sense that the companies that build the core components, like semiconductors, could be in peak demand. These sectors had enormous gains over the past few years, which was why we trimmed positions in the best growers like GE Vernova, Intel and CrowdStrike. It’s important to remember that just because the growth rate slows, this powerful new industry benefits from the existing multi-year buildouts. Companies like Alphabet (Google), Amazon, Microsoft and Nvidia have proven historically that they make massive investments in their business, creating negative cash flows, but resulting in future earnings growth. During these periods of investment their stock prices suffer in the near term but rebound dramatically when the investment cycle is nearing an end. Investors who abandon these names during investment cycles have regretted it.
When capital flows out of one sector it goes elsewhere, thus the strong performance of healthcare and consumer staples sectors. The growth in these sectors is significant, but less sustainable. While many of the businesses improve fundamentals, their increased stock price is disproportionate to the actual business improvement. Illustrative of this phenomenon is Amgen, one of our portfolio companies which is up over 40% in six months. Current momentum in the defensive sector is predictable given our global unrest, but at some point, investors may abandon higher multiples for slow growing consumer products and likely turn to the sexier prospect of Nvidia, which has double digit growth and cash flow.
As we said in our summertime communication, we were trimming winners and adding defensive stocks. Our diversified portfolios already had a healthy allocation to healthcare and consumer staples, which helped mitigate the dramatic drops in AI and tech. We also added to our bond positions. For the first time in a decade, we bought five-year Treasuries because the spike in interest rates allowed us to lock in 5% yields. The losses in the AI trade and tech are painful, and we never like to see gains reduced, but we also value our clients’ after-tax returns. When a client asked why we didn’t sell our entire Intel position when we trimmed, we reminded them of the tax implications. We expect these positions to rebound, but, as ever, correctly timing that resurgence is difficult.
The new Congress will doubtless be less business friendly, but the impact might be less than some believe. Many democrats campaigned on slowing the AI buildout, but they also realize that many communities housing new data centers benefit. Smart data center development means new electrical infrastructure, new jobs, and most importantly, massive contributions to public school funding. Mistakes were made during the early-stage development, but municipalities learned to demand the infrastructure investments needed to mitigate negative community impact. Additionally, if the US clamps down too hard on data center buildout, this development will occur in countries unfriendly to the US outside the jurisdiction of American data privacy laws. Thus, we anticipate some of the campaign bluster will be tempered as the benefits become clearer. A hard stand again AI development will damage our economy and could lead to recession right before the 2028 presidential election. The Biden Administration’s aggressive stance against natural gas pipelines dramatically raised electric prices in places like Massachusetts. Today, the fear of a similar resistance to AI, is driving negative sentiment in the stock market. Lastly, the large majority gained by more moderate democrats in historically red states also mitigates the potentially damaging influence from the far-left, business unfriendly wing of the party, as they can pursue a more centrist agenda without requiring the support of their more fringe members.
As we consider current, future earnings and a stable economy, we see less need to change course despite shifting political winds. Economic growth should remain healthy, corporate earnings are growing nicely and expanding beyond the AI sectors. Washington will have bi-partisan government for at least two years, and markets revel in sustained gridlock. Most importantly, we diversify portfolios and as momentum shifts from sector to sector, we can benefit. Few investors would disagree that valuations were stretched earlier this year and trimming sails makes sense. With that said, it’s painful to watch some of this year’s gains shrink, but the choppy political waters will calm. We have allowed cash levels to rise all year, and investors with investable cash have an opportunity to add to great companies at discounted levels. We will add to some of our favorite investments next week…once the dust settles.
Keep calm and sail on.